Stefan Karlsson's blog

Hard-Hitting Economics Commentary

Saturday, January 30, 2010

Are Tax Credits Really Tax Cuts?

Americans have a much greater aversion towards taxes than the citizens in most European countries. Yet its politicians are as eager as European politicians to use government created economic incentives and other forms of government coercion to manipulate people's life.

How have American politicians solved this dilemma?

In some cases they use regulation as a substitute for taxes. One good example is the government imposed so-called fuel efficiency standards for cars. Except for the aspect that it won't involve any formal monetary transactions, this has a similar effect as a gasoline tax. Because raising gasoline taxes are considered political suicide, Obama and others who want people to use less gasoline won't dare raise gas taxes. Instead they use regulation which impose similar costs for auto makers and drivers as a gas tax, but isn't perceived as a tax.

Another way to resolve this dilemma is to call taxes something other than taxes. The best example of this is the "cap and trade" scheme which Obama and most Democrats have been eager to implement, but which looks politically dead now after "Climategate", the failure of the Copenhagen summit and the victory of "cap and trade" opponent Scott Brown in Massachusetts. "Cap and trade" doesn't sound like a tax, and many of its supporters even call the scheme a "market based solution", yet the fact is that it is a tax. Even if the emission rights are given away rather than auctioned out, it would still be a tax, only combined with subsidies for the companies who are given the rights.

A third way is in a way even more disingenuous than the two aforementioned: the use of so-called tax credits. In this case, not only can the politicians claim that they aren't raising taxes, they can even say that they are cutting taxes. One example of this was in Obama's "State of the Union"-address, where he said:

"We cut taxes for first-time homebuyers. We cut taxes for parents trying to care for their children. We cut taxes for 8 million Americans paying for college."

However, in none of those cases did the tax cut involve reduction of some tax on home purchases, child care or college education. Instead it came in the form of tax credits that told people that they must behave in a certain way in order to keep their money. And that is not a genuine tax cut. As Ilana Mercer puts it in her latest column, commenting on the above Obama quote:

"You lie!: Obama has not cut taxes; he has cut welfare checks for workers, many of whom receive more in reimbursements from the government than they pay in taxes. Moreover – and with a flick of his forked tongue – the president simply redefined the meaning of a tax cut. A tax cut is a reduction in tax rates. It means letting a poor sod (or serf) keep more of his rightful earnings.

Obama's "tax credits" are not tax cuts. Ask Wikipedia, the left-leaning online encyclopedia, according to which tax credits are "subsidies disguised as tax cuts. In other words, they are spending in the form of direct transfers from the treasury to individuals, except that they are administered by the tax authorities rather than the agencies usually responsible for welfare."

A better definition of tax credits is social tinkering or engineering, as they target certain politically desirable constituents to the detriment of others. "Taxpayers can receive a raft of tax credits if they engage in various government-specified activities," confirms Peter Ferrara, director of entitlement and budget policy for the Institute for Policy Innovation."

The problem here is first of all that many of these tax credits are refundable, meaning that some can get them even though they're not paying taxes. A second and perhaps even more serious problem is that they for all practical purposes work as transfer payments or government consumption expenditures.

In Sweden and most other European countries, child care and college education are paid partially or fully by the government. People who use these services generally don't feel that they're getting a hand out however, because these subsidies are financed by taxes that they or their parents are paying. They are in other words simply keeping money that they have earned and otherwise would have gone to others. This is exactly like the tax credits that Obama brags about. While the formal arrangements differ somewhat, in terms of both the distributive effect and the effect on incentives, tax credits are essentially the same as subsidized services received by tax payers. Both have the characteristic of enabling people to keep money that they've earned and both have the characteristic of inducing some people to do things they wouldn't have done in the absence of taxation.

Some libertarian supporters of tax credits, such as Murray Rothbard, claims that people skeptical about tax credits assume that all income really belongs to the government. But that is not true as the problematic aspect is not that government finances are weakened (direct spending do that too), but that government manipulates behavior by telling them that they must buy certain services or perform certain activities or the government will not let them keep that income.

Rothbard's counter-argument to the fact that tax credits distort behavior, that in the absence of tax credits more money will go to the government, is in fact just a version of his previous argument, and fails for the same reason. Except for when tax credits are reduced as a fiscal austerity measure (and this applies equally to other fiscal austerity measures such as spending cuts or marginal tax rate increases), all revenues will through transfer payments, government services or marginal rate tax cuts ultimately go back to households. So the issue isn't whether or not households or government will be financial net receivers, the issue is whether or not government decides how money will be spent. If marginal tax rates are reduced, then government will decide less, but if the government increases spending on or issues tax credits for certain forms of behavior then government will increase its influenc

-More than a quarter of that growth was illusory, as the domestic purchases deflator rose 2.1% while the GDP deflator rose 0.6%, meaning that terms of trade adjusted GDP rose 4.2%, not 5.7%.

-Many of the assumptions of this preliminary numbers seems over-optimistic (for example on structures and the trade deficit), meaning that the number will probably be revised down, just like the third quarter number was revised down from 3.5% to 2.2% (and could be downwardly revised further in the annual reviews).

-Of the now reported 4.2%, no less than 3.4% depended on reduced inventory reductions. That doesn't make that growth less real, but it does suggest that growth will likely slow down.

Obama's Spending Contradiction

I really don't agree with left-liberal Keynesian Brad DeLong on much, including on the issue of whether government spending should be increased or not, but he is right when he points out that Obama contradicts himself when he A) Says his policies aims to create more jobs B) Says that the spending increases in the stimulus package created jobs because the economy operated under less than full capacity C) Says he wants to freeze some spending when the economy will still be operating under less than full capacity.

You can believe in both A) and B) at the same time, and you can believe in both A) and C) at the same time and you can believe in B) and C at the same time, but you simply can't believe in A), B) and C) at the same time.

Tuesday, January 26, 2010

Myths About Chinese Foreign Exchange Reserves

In his latest column, Robert Samuelsson repeats the myth promoted by Paul Krugman and many others that the Chinese foreign exchange reserves are a measure of its mercantilist trade policies.

This is however not true. To understand why, let's recall that first of all, an exchange rate is determined by the demand and supply for a currency. Demand and supply is in turn a function of first of all foreign demand for domestic goods (goods& services market demand for the domestic currency), domestic demand for foreign goods (goods and services market supply of the domestic currency), foreign demand for domestic assets (asset market demand for the domestic currency) and domestic demand for foreign assets (asset market supply of the domestic currency). For simplicity we can simply use net demand for foreign goods (the trade or current account balance) and net demand for foreign asset (capital flow balance).

At the same time we must remember the balance of payments identity, that the current account balance must be financed (or finance) a capital flow balance of the opposite sign, so that the total balance is zero

CF+CA=0

Where CA is the current account balance and CF net capital (in)flows. If we rewrite this by subtracting CA on both sides it becomes:

CF=-CA

The exchange rate is the thing that changes whenever the current account balance moves independently of the capital flow balance so as to ensure that for example increased net exports by some is counterweighed by decreased net exports by others or an increase in net capital outflows.

In the context of China and other countries that pursues a fixed exchange rate policy, a further distinction must be made, namely between private capital flow balance and government capital flow balance (The build up or depletion of foreign exchange reserves). This would create this new balance of payment identity (by subtracting private capital inflows from the rewritten balance of payment identity):

GCF=-(CA+PCF)

GCF is of course government capital flow and PCF private capital flow. If a country then has a current account surplus and net private capital inflows this means that there must be net government capital outflows, or in other words that foreign exchange reserves (or sovereign wealth funds in other countries than China) must increase.

Or in other words, whenever foreigners increase supply of their currencies by buying more domestic goods or assets, this means that this must be counteracted by increased government purchases of foreign currency. So, whenever some one buys either Chinese goods or services or Chinese assets this means that the Chinese central bank will expand its foreign exchange reserve.

Let us then analyze the effects on foreign exchange reserves from different policies. If China kept the exchange rate fixed and established that the policy was credible, then this might result in a big current account surplus that would be counteracted by big Chinese foreign asset purchases.

If the exchange rate started to appreciate, then the Chinese current account surplus would probably decrease, but as this would create expectations of further appreciation it would also increase private capital inflows into China. The increase in private capital inflows could very well be larger than the decrease in the current account surplus, meaning that foreign exchange reserves would have to grow.

So, despite the fact that this currency appreciation would make China's currency policy less mercantilist in the sense that its current account surplus would shrink, its foreign exchange reserves might just grow even faster. Because of these dynamics, it is simply not true that the change in foreign exchange reserves in an indicator of whether or not the currency policy is mercantilist or not. Samuelsson and others who believe that implicitly assume that private capital flows doesn't exist or aren't affected by exchange rate expectations, assumptions which are false.

A related myth is that the change in foreign exchange reserves is an indicator of whether or not the currency is cheaper than it would have been under a floating exchange rate system. Leaving aside for now the issue of whether this should be considered an ideal, it can be said that while it is not quite as misleading as whether or not the policy is mercantilist, it is still misleading.

Assume for the sake of argument that the current yuan/dollar exchange rate is basically identical to the one that currently would have present under a floating exchange rate system, and that in the future the average exchange rate would by chance have stayed basically unchanged. Assume then that the central bank would ensure that it appreciates 5% per year. This would greatly increase private demand for yuans, forcing -in order to limit current currency appreciation- the Chinese central bank to increase its demand for foreign currencies. In this case, the yuan would become overvalued relative to the exchange rate it would have had under a floating exchange rate system, even as Chinese foreign exchange reserves would increase.

This is not to say that the current policy is ideal, it certainly isn't, and while a free float (or a big one time revaluation) would be associated with disadvantages, it would be a lesser evil for China and the world compared to the present system. However, it is misleading to say that the amount of foreign exchange reserves measures how over- or undervalued it is, and because of the above mentioned factors, a gradual appreciation of the yuan would probably not reduce the problem of excessive foreign exchange reserves.

Monday, January 25, 2010

The False Choice

Newsweek argues that because of the financial crisis, there will be a shift from free market economics to interventionist economics. In the sense that the crisis has created more support for government intervention and more actual government intervention that is a correct account.

But the article goes beyond that and also argues that this is right because the crisis showed that the Chicago School account of markets as being completely efficient (as in flawless) was wrong. And while it is true that this meant that the Chicago School doctrines were again shown to be false, this does not mean that free market economics is discredited, because there is a sounder alternative in the form of the Austrian School, whose theories does not assume that markets are "perfect", only that market mechanisms are better (or less bad) than the alternative of government interventions.

And contrary to the implicit assumption of the article, markets were hardly entirely free, with for example (this is the most important, but not the only example) short-term interest rates set by a government agency, the central bank. As always when governments fix prices, the fixing of the price of short-term credit did cause the predictable problem of too much credit when the price was set arbitrarily low.

This illustrates why free market advocates that use the New Classical/Chicago School theories are often doing more harm than good. By presenting themselves as the alternative to Keynesianism, they allow the Keynesians to present themselves as the most realistic alternative in the false choice between New Classical/Chicago Shool theories and Keynesian theories.

Saturday, January 23, 2010

Should Bernanke Be Re-Appointed?

Some (most) of my readers probably thinks that my answer to that question is something like "Hell no!". And if there was a better alternative that would indeed be the correct answer. But as the situation is right now I, like Paul Krugman, find myself undecided with mixed emotions (though my reasons are of course radically different from Krugman's).

On the other hand, who would replace him? Hardly any Austrian, or other sound money advocate. Instead it would most likely be someone (perhaps Larry Summers) with similar views who would pursue similar policies. Only that person would with his looser connection to the housing bubble or "Helicopter"-reputation gain more trust and be less vulnerable to criticism.

So, as richly as Bernanke deserves to be ousted, doing so might not make things any better. It could in fact make things slightly worse.

The truth about the issue is that Greece's public finances are indeed in a bad shape, but that it is not likely that Greece will default or exit the euro.

One part of the problem is that Greek statistics have proven unusually unreliable. All government statistics should be taken with a grain of salt, but Greek statistics are particularly unreliable-particularly with regard to public finances.

Case in point is the 2009 budget deficit which according to the new government was much greater than what the previous government reported it to be. And this is not the first time that such irregularities existed. The fact that statistics are unreliable makes the problem much worse since the uncertainty will in itself create an extra risk premium on Greek bonds.

Assuming that the current statistics for 2009 are reliable (and that seems likely. And it is more likely that the current government might even exaggerate the deficit to make their predecessors look worse than it is that they would want to underestimate the deficit they inherited) the situation is indeed bad with a deficit of over 12% of GDP and a debt of 109% of GDP. That is not uniquely bad as there are countries (for example the U.K.) that have a bigger deficit or a bigger debt (for example Japan), but unlike the U.K. and Japan, Greece doesn't have the ability to print money, making it potentially vulnerable for a formal default. It is much more difficult and dangerous to be fiscally irresponsible if you lack your own currency and the ability to print it (or if the government debt is denominated in a foreign currency), something which both Greece and California have experienced.

Furthermore, the worries about Greek debt risks being a self-fulfilling prophecy. The more markets worry about it the higher will yields go something which in turn will cause the deficit to increase further (because of higher interest cost), something which will raise yields further and so on in a vicious circle.

Given the magnitude of the yield increases in some days, it seems likely that we are not just talking about investors selling their holdings but also of hedge funds and others selling Greek debt short.

So there is indeed a possibility of default-but it is not a very likely possibility. Speculative attacks of this kind are usually short-lived and the Greek government does seem committed to fiscal austerity measures. While the current panic will increase interest costs, it will also increase the determination of its politicians to reduce the deficit and increase public support for such measures. In the past when the price for doing so was low, it was difficult to convince the Greeks of the dangers of deficit spending, but now the rules have changed.

And ditching the euro in order and bringing back the drachma to enable the politicians to inflate way out of trouble is highly unlikely. First of all because it would be inconsistent with the rules of EU membership and secondly because Greek debt is denominated in euros. If the drachma was reintroduced it would almost surely drop in value dramatically against the euro, increasing the burden of euro denominated debt dramatically, worsening the debt crisis.

With all this in mind, it seems clear that Greek bonds are significantly undervalued from a fundamental point of view. The current yield spread against German bonds imply (for 10-year securities) a 100% certainty of a 30% default (that the Greek government will only pay back 70% of the nominal value), assuming 0% risk of any kind of default on German bonds. Or alternatively that there is a 30% risk that the Greek government will repudiate its entire public debt, something which would be unprecedented for a civilized country (With the exceptions of for example the newly created Soviet Union repudiating the debts of the Russian Empire, it has almost never happened anywhere). While the risk of some kind of partial default is clearly higher for Greek bonds than for German bonds (justifying a smaller yield spread), it is not anywhere near that much higher.

A key reason for this combination of rising economic growth and inflation is an excessive rate of money supply growth with M2 rising 27.7%. The Chinese central bank appears to realize that this is way too high and have already started to take steps to rein it in. However, the steps taken so far will prove to be insufficient, forcing them to take further steps. If they act forcefully soon, then malinvestments and asset price bubbles can be contained to manageable levels. If however they do not act forcefully soon, then China faces a more serious future crisis.

It would be wrong however to view current growth as merely a result of an excessive credit boom. It is mainly the structural strengths of the Chinese economy that drives its growth and in 2009 important progress was made. In 2009, China overtook Germany as the world's biggest exporter and America as the world's biggest car market (and market for many other durable consumer goods). Unless there is a really dramatic rally (which is unlikely) in the yen, China will in 2010 surpass Japan as the second biggest economy (on a purchasing power parity basis China is already a lot bigger) in the world.

Tuesday, January 19, 2010

U.K. Inflation Rises Dramatically

Largely (but not entirely) because the VAT cut in December 2008 was taken out from the base comparison, U.K. price inflation jumped from 1.9% to 2.9% in December 2009. Underlying inflation was a lot higher previously during 2009 but was held back by the VAT cut. Once that the actual reversal of the cut starts to show up in coming months, it seems safe to say that inflation will jump significantly above 3%.

This should hardly surprise anyone. You can't debase a currency the way the Bank of England has done and not expect the domestic purchasing power of the currency to slump.

Both British bond yields and the pound's exchange rate rose in response to the news, as belief increases that the Bank of England will have to reverse its inflationist policies. Given that the recovery remains very weak, I however doubt that there will be any monetary policy tightening anytime soon. And before they start to raise interest rates, they will likely first start to trim its quantitative easing first.

Monday, January 18, 2010

Paul Krugman Lies About Reagan & Taxes

In his usual pattern, Krugman distorts the record about the Reagan tax cuts. First of all, he shows in his chart when tax changes were passed and not when they were implemented. While future tax changes can affect current behavior, surely the main effect comes when they are implemented.

And secondly, and more importantly, while it is true that in 1981 a tax bill was enacted that reduced taxes and that in 1982 one (or actually two) tax bill was enacted that raised taxes, the 1981 tax bill reduced tax revenues gradually over several years, meaning that it caused tax rates to fall not just in 1982 but also further reduced them in 1983, 1984 and 1985. And the net effect of the 1981 tax cut bill was a further 1.39% of GDP tax cuts in 1983 and a further 0.98% of GDP tax cuts in 1984. This compares with the 0.58% tax increasing effect of the 1982 bills in 1983 and the additional 0.6% tax increasing effect in 1984. Meaning that the net tax cuts in the boom years of 1983 and 1984 was 0.81% in 1983 and 0.38% in 1984.

(See here for a summary of the size of the tax cuts in different years)

The one thing true in Krugman's post is his admission that monetary policy played a very important role both in the 1982 slump and the very vigorous 1983-84 recovery. However, it is very misleading to suggest that the 1983-84 recovery happened in the context of tax increases, since the implemented tax cuts were much bigger than the implemented tax increases.

Sunday, January 17, 2010

2 & 10- Year Currency Movement Summaries

Following up on this post about 2009 currency movements (Which was a follow up on this post about 2008 currency movements), I now give you first a 2-year summary and then a 10-year summary. As was noted before, the winners of 2008 performed relatively bad in 2008 and vice versa. However, while for example the Brazialian real and the Australian dollar made up for their entire 2008 loss and ended higher on December 31, 2009 than December 31, 2007, the British pound and the South Korean won was nearly a fifth lower in late 2009 compared to late 2007 despite recovering somewhat during 2009. Some inflationists might interpret the strong recoovery in South Korea in 2009 as evidence of the benefits of a debased currency, but that overlooks that Brazil and Australia aslso had relatively strong economies, while the U.K. economy remained weak. Here is then the aggregate 2-year change relative to the U.S. dollar:

Another observation that can be made from this is that it is curios that people attack China so much for supposedly keeping its currency so low when the yuan in fact has been much stronger (+21.3%) during the latest decade than other Asian currencies, including the Singapore dollar (+18.0%), the yen (+9.8%), the South Korean won (-3.1%) and the Indian rupee(-6.4%).

Why Australia Faces More Interest Rate Hikes

In this article in The Australian it is explained why the Reserve Bank of Australia will face more interest rate increases (Just like Israel and probably also China). While I disagree with some of the implicit theoretical arguments of why inflation will rise, the point is that the Reserve Bank of Australia believes in them, meaning that they will continue to raise interest rates. This is bullish for the Australian dollar, though the upside potential is greatly limited by the fact that it has already rallied so much.

Saturday, January 16, 2010

The Laws Of Economics Can't Be Repealed

That Venezuela's socialist ruler Hugo Chavez is a nutcase is hardly news. The latest example is quite instructive though. First he devalued Venezuela's currency by 17% for "priority imports" and by as much as 50% for imports that are not considered essential. Presumably, the lower rate will apply to exports as well.

Having two exchange rates for the same currency is of course loony enough as it will encourage arbitrage and create various distortions (it is not clear why he simply didn't instead slap [higher] tariffs on these "non-essential" imports) , despite Chavez' tirades and violent actions against "speculators".

Now he denounces any businessman who raises prices in response to the higher cost of imports as a "bourgeois speculator" and threatens to use military force against these "bourgeois speculators".

Price controls of that kind have been tried many times before in history, and to the extent they were enforced they meant either shortages or that the government were forced to subsidize it. If Chavez thinks that he can in some cases double the cost of goods and expect them to have the same retail price, then few or no retailers will want to sell them. If Chavez' thugs are sent to seize these businesses in response, then it will be the Venezuelan government who will have to sell the goods at a loss-something which will be very costly for the government.

Either way Chavez can't repeal the laws of economics in the same way that he can repeal man made laws. Higher costs of imports will ultimately mean either higher costs for Venezuelans-whether be for the consumers in the form of higher prices or for the government in the form of subsidies- or that shortages will appear. The laws of economics are just like the laws of physics something which politicians or anyone else can't change or escape.

U.S. Industrial Capacity Continues To Drop

Industrial production rose 0.6% in December in America. However, that reflected almost entirely a 5.9% gain in utilities (electricity) reflecting the cold weather conditions. Mining rose only slightly, and manufacturing fell slightly. While that slight fall followed a 0.9% gain in November, it was clearly a weak number, especially relative to the manufacturing purchasing manager's index.

What few have noticed in all of this is that manufacturing capacity is falling at a rapid pace. It was 1.3% lower in December 2009 than December 2008, and the pace is accelerating with capacity dropping 0.5% the last 3 months (which translates into a 2% rate.

The implications of this is stagflationary as lower capacity means in effect lower potential supply, and lower supply means both lower output and higher prices.

Wednesday, January 13, 2010

Greek Party(ing) Is Over?

As part of its fiscal austerity program to reduce its large budget deficit, the Greek government plans to raise taxes on alcohol and tobacco. So not only can one say that the Greek party is over figuratively speaking, there will be less partying in Greece for its citizens. At least it will be so using alcohol and tobacco bought legally in Greece. Higher alcohol taxes have a tendency to encourage moonshining, smuggling and purchases in other countries. Because of that, this tax increase might not generate as much extra revenue as the Greek government hopes.

China Will Tighten Monetary Policy More

The current rapid Chinese boom has two sides: one unsound side in the form of the structural strength of the Chinese economy with a high savings rate, shift of resources from the rural sector and limited government spending. The second factor is an excessive credit boom.

The structural strength of the Chinese economy means that long-term prospects remain bright. However, the credit boom risks creating even more malinvestments and asset price bubbles, which in turn threatens growth.

The latest move to increase reserve requirements is a step in the right direction, but it is certainly not good enough. China should and most likely will move forward with more actions to restrain credit growth. Higher reserve requirements is one effective measure to achieve that, ending or reducing tax breaks for exporters is another move that would be effective (a lower trade surplus will reduce the need to expand the central bank balance sheet, and so restrain monetary inflation).

Raising interest rates and allowing the yuan to appreciate could perhaps also achieve it, but the risk is that higher interest rates and an appreciating currency will lure even more "hot money" into China, causing the central bank balance sheet to expand. Recent moves to restrict such inflows will reduce that risk, but not eliminate it.

But regardless of which sort of action they choose, it seems very clear that they will be forced to continue with more tightening measures as the latest one will prove insufficient to bring down credit- and money growth to more sustainable levels.

More On Government Spending & Growth

Between 1980 and 2000, direct state & local government spending was exactly unchanged at 11.6% of GDP. In the third quarter of 2009, that number had risen to 12.6%, further re-enforcing the overall picture of a record large American welfare state.

One objection to my argument might have been that the reason why government spending increased relative to GDP was that GDP slowed down for other reasons, not that government spending increased faster. While there is a limted degree of truth in that argument, it is only a very limited degree as it overlooks first of all how slower GDP growth should lead to slower growth of government spending, since this makes it cheaper for the government to lure away workers from the private sector. Slower GDP growth may not "naturally" slow government spending fully as much as GDP itself (leading to a higher burden of government), but it will reduce the absolute level of growth.

And secondly, while the absolute level of growth of state & local government spending was slightly lower in absolute terms (they can't print & borrow like the federal government so slower economic growth limits their ability to spend in a way which is not applicable for the federal government) growth of federal spending was in fact faster in the 2000s than in the 1980s and 1990s.

Real federal spending (excluding interest payments) increased by 2.1% per year between 1980 and 2000. If you also exclude military spending the average annual growth rate was 2.5%. By contrast real federal spending excluding interest payments increased 4.5% per year between 2000 and 2009. If you also exclude military spending, the average annual growth rate was 4.1%.

And finally, I should also mention that in an analysis of European economies the same negative relationship between the change in the burden of government and growth.

The People Who Denied The Housing Bubble

Interesting list of prominent pundits that denied the existence of a housing bubble. The list is far from complete though, as it not only excludes government officials like Greenspan and Bernanke, but also for example Larry Kudlow and Art Laffer.

Chinese Trade Surplus Drops Sharply As Trade Volumes Recover

Many critics of the Chinese currency policy have argued that it amounts to mercantilism, and that while the Chinese surplus may have fallen because of the crisis, it will rise again once global trade recovers.

Particularly the latter claim is difficult to square with the December Chinese trade numbers, which showed that the surplus dropped by more than 50%, following a 17.7% increase in exports and 55.9% increase in imports.

Krugman On American Growth & Government Spending

Paul Krugman has a column where he notes that some conservatives worry about America becoming more like Europe in terms of a bigger welfare state and then claims that Europe is at least as successful as America, supposedly meaning that there's nothing to worry about.

First of all, advocates of limited government are usually not for it just because of economic efficiency arguments, they (we) view freedom from government as a self end or desirable because of other reasons. That may be hard for Krugman to relate to, but that is similar to how leftists view economic equality as a self end or desirable for other reasons. Thus, even if it didn't harm economic efficiency, many would oppose bigger government.

And secondly, it is misleading to compare simply levels of government spending with growth. The level of government spending is perhaps more accurately associated with the higher income level in America. For growth, change in government spending is at least as important as the level. And for America, it is very misleading to discuss the 1980 to 2009 period as just one period, because government spending changed in a very different way during the 1980 to 2000 period, and the 2000 to 2009 period.

During the period of 1980 to 2000, federal spending fell from 21.7% of GDP to 18.6%. The drop was even bigger excluding net interest, from 19.8% to 16.1%. Some of that reflected the "peace dividend" from the end of the cold war, yet if you also exclude military spending, federal spending fell from 14.9% in 1980 to 13.1% in 2000.

Then comes the 2000 to 2009 period when federal spending soared from 18.6% to 22.2% (excluding outlays for TARP and similar items). The increase was even bigger excluding net interest, from 16.1% to 20.8%. If you also exclude military spending, the increase is somewhat smaller, but it still rose from 13.1% to 16.3%-which is a new all time high.

America has thus rapidly been moving towards a much larger welfare state in the era of Bush and Obama-and not coincidentally, growth dropped dramatically in the 2000s compared to the Reagan-Clinton years of the 1980s and the 1990s when welfare state spending dropped relative to GDP. During the 2000s, growth was just 1.6%, compared to 3.2% in the 1980 to 2000 period. Assuming 1% population growth, per capita income growth dropped from 2.2% in the era of reduced burden of government to just 0.6% in the era of increased burden of government.

Sunday, January 10, 2010

The Lessons From The Depressions Of Ukraine & Latvia

The two European countries that have suffered most from the economic crisis are arguably Ukraine and Latvia.

The two have a lot in common as they both used to be part of the Soviet Union, and as a result both have a large ethnic Russian minority. Both are seeing its population shrink due to a low birth rate. Both saw big output declines in the 1990s, followed by very rapid growth throughout most of the 2000s. In both cases, the booms were in part the result of tax cuts, in part the result of inflationary credit. Because of the latter factor, both had huge current account deficits at the peak of their booms.

There are significant differences however, not least in terms of currency policy. Latvia's currency, the lat, has a fixed exchange rate against the euro, while the Ukrainian currency, the hryvnia, has a floating exchange rate, or perhaps more accurately a sinking exchange rate, with the hryvnia losing more than a third of its value against the euro and the lat (which in inverted terms means that the the euro and the lat is up more than 50% against the hryvnia).

Both have had really dramatic declines in output. The question of which of these two countries had the biggest drop depends on what measure of GDP change you use.

Using the standard volume measure, it is Latvia. Latvia's volume GDP dropped by 19% in the year to the third quarter, while Ukraine saw its volume GDP drop by 15.9% during the same period.

Using the more accurate terms of trade adjusted measure however, Ukraine has had the biggest drop in output. Adjusted for terms of trade, Latvia's drop in GDP was 20%, while Ukraine's adjusted GDP dropped by 22.5%. The reason for this is that import prices in Ukraine rose as much as 74.5% while export prices rose by "only" 49.8%. In Latvia the difference was much smaller with import prices falling 7.4% while export prices fell 10.3%.

Still, regardless of what gauge you use the difference isn't that dramatic. Both Latvia and Ukraine have clearly been in an economic depression.

The main difference is that Latvia is in a deflationary depression, while Ukraine is in an inflationary depression. The domestic demand deflator fell 2.5% in the third quarter in Latvia, while it rose 13.9% in Ukraine. This difference can be directly attributed to the difference in currency policy, something which is illustrated by the fact that export and import prices fell even more than domestic prices in Latvia, while export and import prices rose far more than domestic prices in Ukraine.

How has this difference in currency policy affected the depth of their depressions? As I noted in my discussion of the pros and cons of a devaluation in Latvia, it can be expected that devaluation in an ideal situation (with no foreign currency debt) would make the slump milder in the short term, while also producing a lower adjustment.

However, given the reality of large foreign currency debts, the above will not necessarily hold true, and the big slump in Ukraine (which like Latvia has large foreign currency debts) confirms that devaluation does little to ease the slump in output.

The main benefit produced by the devaluation/inflation path of Ukraine is that the increase in unemployment has been limited, rising from 6.5% to 9.4% in the latest year. By contrast, unemployment has increased far more in Latvia, from 10.2% to 22.3%.

The reason why the increase in unemployment has been much smaller in Ukraine is that the high level of inflation there has reduced real wages dramatically, by more than 10%. By contrast, real wages have dropped only about 4% in Latvia given the 2.5% deflation rate (and only 1% in the private sector), and the small drop we've seen can mostly be attributed to the consumption tax increase.

Saturday, January 09, 2010

Reasons For A Bearish Outlook

The chart below (HT Stephen Spruiell) illustrates why we can't expect a recovery anywhere near as strong as the one we saw in 1983-84. There are a few factual errors (inflation was not 10% and the budget was not moving towards a surplus in 1982. And I do not believe that the savings rate is rising or that it would be bearish if it did), but most points are correct and the few errors have little or no significance.

Friday, January 08, 2010

U.S. Employment Numbers Weakens Again

While the unemployment rate was unchanged, that was only because the participation rate again dropped. The employment rate fell from 58.5% to 58.2%-the lowest since July 1983, and down from the peak level of 64.7% in April 2000. The household survey in fact said that employment fell by as much as 589,000.

The more reliable (at least when it comes to monthly fluctuations) payroll survey indicated that "merely" 85,000 jobs were lost. But that's bad enough, especially considering that the population is growing, and the fact that the household survey has tended to be a lot weaker during the latest year (Aggregate household survey job loss was 5.4 million, while the aggregate payroll survey job loss was 4.2 million) indicates that the payroll survey likely underestimates job losses. The reason why the payroll survey likely underestimates job losses is probably related to the flawed "birth-death" model which is not actually part of the real survey but is imputed into it by Bureau of Labor Statistics statisticians.

Moreover, unlike in the previous month, the average work week did not increase while the increase in average hourly earnings held steady at a low level (however, the November increase was upwardly revised). Together with the increased loss in jobs, this means that nominal income growth likely slowed dramatically, and is likely non-existent after adjusting for inflation.

And like in the previous month, there is questions about the seasonal adjustments given last years big declines in employment, which could have been misinterpreted as seasonal rather than cyclical (or structural) by the seasonal adjustment models.

Was there anything bullish in the report then? No, not really, except for the aforementioned small upward revision of the November average hourly earnings number. And the report is also strong in a relative sense compared to late 2008 and early 2009 where we saw big drops in all relevant numbers except for average hourly earnings. The economy and the labor market is clearly not contracting in the way we saw then. However, these numbers also clearly indicates that we are not seeing a robust recovery. While the economy is probably growing, it is growing only very slowly and the labor market isn't growing at all.

Thursday, January 07, 2010

Oil & Price Inflation

Peter Boockvar at The Big Picture writes that he "hate[s] to take one commodity and declare there is inflation or deflation" yet nevertheless proceeds to focus on one commodity (oil) or more correctly a refined product of that commodity (gasoline) because he says it helps to drive inflationary expectations. There is a limited degree of truth to this as gasoline prices probably affects inflationary expectations, and inflationary expectations affects future price inflation.

However, there are other factors that are more influential than gas prices in driving inflationary expectations and other factors are also more influential than inflationary expectations in driving future price inflation, making that link relatively weak.

On the other hand, higher cost of energy and transportation is something which will increase the cost of production of other goods and services, something which will cause future price increases for other goods and services (this is why "core" inflation is a lagging indicator of inflation).

It could by the way be noted that oil is hardly the only commodity that have increased in price. Though commodity prices fell back slightly today (January 7) they have recently been making new post-financial crisis highs even in U.S. dollar terms and even more so in terms of other currencies such as the euro, the yen and the U.S. pound. While base effects have started (and will continue to) to reduce the annual increase, the absolute level keeps rising and the annual increases in the broader commodity price indexes are still very high (22 to 45%).

Price inflation will therefore remain elevated in the near future and will in fact at least outside the U.S. (where the stronger dollar will limit increases in the inflation rate) continue to increase.

Tuesday, January 05, 2010

Stock Markets & Economic Growth In The Long Run

This report reminds us that while U.S. (and European and Japanese) stock markets had a "lost decade" in the 2000s, so-called emerging market stock markets have produced good returns.

Most likely, this trend will continue for awhile. The reason for this is that growth capacity is much stronger in China, India and other emerging economies than in the U.S., Europe and Japan.

Low investments and more statist policies will drag down the U.S. economy even more during the coming decade than in the preceding, something which is also true for many European countries. For Germany and a few other European economies and even more so Japan, demographic factors will further limit growth as both the supply of labor and capital shrinks as populations shrinks and ages.

China, India and other emerging market economies have far better structural prospects, something which means that stock market returns will likely also be better in the long run, though many faces a significant risk of short-term corrections given the current inflationary conditions created to compensate for loss of exports.

Some might argue against this link between economies and stock markets because companies are far more globalized in the past, meaning that U.S., European and Japanese companies can prosper even though their economies stagnate. But while that weakens the link, it does not end it. Higher economic growth is usually associated with the emergence of highly competitive domestic companies that challenges companies from slower growing economies, something which reduces the extent to which companies from slow growing economies can grow faster than their economies.

One good example of this is the Japanese stock market which has been weak for two decades despite the multinational nature of many of its companies. While Toyota and a few other Japanese companies have performed much better than the overall Japanese economy, other Japanese companies have lost market share in foreign markets (and perhaps also market share in the Japanese market) due to the emergence of tougher non-Japanese competitors.

Monday, January 04, 2010

Scyscrapers & Booms

Many other tall buildings, including for example the Empire State building in New York in 1931 and the Petrona Towers in Kuala Lumpur in 1998 were similarly associated with cyclical slumps.

Coincidence? No. Causal Relationship? Not in the direct way that the building of the tower was the underlying cause of the boom, though the extra debt needed to finance it probably made things slightly worse. Instead, the key way in which the two relate is that both were the result of unsustainable monetary expansion.

But while unsustainable credit booms could cause the construction of extremely tall buildings, the relationship is far from perfect since some booms do not result in it. Thornton mentions the example of Japan in this respect. And furthermore, there are a lot more examples of skyscrapers being built without being associated with an economic crisis.

The best example of this is the building that between 2004 and now was the tallest in the world, Taipei 101 (508 meters or 1,667 foot). There was no significant cyclical slump in Taiwan after the completion of that building, and none in China after the completion of Shanghai World Financial Centre (492 meters or 1,614 foot). While both China and Taiwan suffered from the global economic crisis in 2008, the Chinese slump was very mild, the Taiwanese very far away in time from the construction of the building and both have now recovered fully. And in neither case was the slump caused by domestic credit booms.

This illustrates that skyscrapers need not be the result of unsound credit booms. It could just as well be the result of sound economic booms (Of course, there were unsound elements in the Chinese and Taiwanese booms-but the sound elements dominated. And it is even more true that there were sound elements of for example the U.S. boom in the 1920s).

Bernanke Fails To Exonerate The Fed

Here we go again, another Fed official tries to exonerate the Fed (or at least the Fed's monetary policy) from having caused the housing bubble. This time it is Bernanke himself in his latest speech. For Bernanke it is of course very important to try to exonerate the Fed since he was a leading advocate (together with Greenspan) of that policy, and since this could cause people to try to restrain, audit or even abolish the Fed. Blaming it on insufficient regulation of "exotic mortgages" by contrast would perhaps enable the Fed to increase its power.

I won't bother commenting on every error in the speech, and will instead focus on the most relevant errors with regard to the issue of the role of monetary policy.

1. Bernanke tries to measure monetary policy influence by the so-called Taylor rule and argues that with a different definition of the Taylor rule, monetary policy wasn't so loose.

But the Taylor rule is hardly a good gauge of monetary policy since first of all it has never been demonstrated or proven just why it is good and secondly because there isn't just one Taylor rule, there are dozens different Taylor rules being used. And with people adjusting the variables in the Taylor rule equation more or less arbitrarily to suit their own purposes (Bernanke's new version in the speech is in fact a perfect example of this), it becomes for all practical purposes useless in discussions between economists.

2. Bernanke tries to argue that based on the data they had then (which showed lower inflation then current revised statistics for the period) and given his own version of the Taylor rule, monetary policy was appropriate for stabilizing the economy. But since the economy turned out to be anything but stabilized, this only demonstrates that his policy approach is a failure.

3. Bernanke then tries to argue that monetary policy couldn't have been involved because other countries had house price booms despite supposedly more restrictive policies.

But that is misleading for several reasons. First of all, he uses the Taylor rule for evaluating policies, but that is problematic for above mentioned reasons. Secondly, the numbers he uses that are inaccurate or misleading for several reasons, including the fact that house price increases are not necessarily reflective of a bubble. It could also reflect previous undervaluation or structural factors like higher growth.

Because a monetary policy driven house price boom will eventually cause other prices to increase, forcing the central bank to raise interest rates, monetary policy driven house price booms are by their nature bubbles.

And while he tries to say that low rates couldn't have been involved because others didn't have it he fails to notice that in many other countries with housing bubbles (such as Spain), "exotic mortgages" and other things he blames for the U.S. bubble did not exist. Thus by his own method of evaluating explanations, his own explanation is refuted.

4. His other preferred explanation, capital inflows, is pathetic for other reasons, including the fact that capital inflows (otherwise known as current account deficits)are the effect of housing bubbles, not the cause. When you have a credit driven boom, demand for foreign building materials and other foreign products increase, causing the current account deficit.

While temporary capital inflows could under certain circumstances theoretically cause a housing bubble (namely if foreign investors invest in a certain country in an unsustainable way and then suddenly decides to stop investing in that country) the timing doesn't fit the U.S. bubble, which started in 2001 when the current account deficit fell, and stopped in 2006 even though the deficit continued to increase.

Saturday, January 02, 2010

Summary Of 2009 Currency Movements

One popular post last year was "Summary of 2008 Currency Movements" so I'll have a similar post this year. Like last year, the aggregate currency movements sometimes hid more dramatic intrayear movements. The euro was up 3.5% against the U.S. dollar this year, yet that masked a drop of about 10% between December 31 2008 and March 5 2009, followed by a 20% euro appreciation until November 25, after which it fell 4.5%. Even so, the full year numbers are certainly of great interest.

The dollar generally fell this year against other currencies, with some of last year's losers, such as the dollars of Australia and New Zealand and the Brasilian real being the great winners. On the other hand, last years great winner, the yen, was the only major currency to depreciate against the U.S. dollar this year (the yuan also depreciated, but by only 0.06%, rounded up to 0.1% below). The values are for change relative to the USD was:

Of course, the high growth numbers for South Korea, Taiwan and Hong Kong is largely due to a base effect created by the depressing numbers they saw in late 2008, but they nevertheless show that the Asian economies have recovered fully from that slump and they are now in most cases showing even higher levels of output and trade than before the crisis.

Growth in these countries are mostly driven by the boom in China. South Korea for example saw exports to China rise 74.4%, while exports to Europe rose by 49.4% and exports to the U.S. rose just 8.7%. China for its part saw its manufacturing survey index rise to a 20-month high in December.

Recent indicators suggests that growth is increasing in Europe and the U.S. too, but nowhere near as fast as in most Asian countries. As long as it lasts, the Asian boom will help drive commodity prices even higher. The dependence on China is however not entirely a good thing given that its boom is partly unsound (partly driven by excessive money supply growth).

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